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The Quarterly Report - July 2017

July 18, 2017

The second quarter of 2017 picked up right where the first quarter left off as ‘sell in May and go away’ would not have been a wise move, with equity markets continuing to hit record highs. GDP in the first quarter increased at an annual rate of 1.4% (still anemic) with help from higher consumer spending and exports. Domestic jobless claims continued their trend lower and the unemployment rate fell to a 16-year low 4.3% in May.

Equity returns were positive around the globe as emerging markets outpaced both domestic and developed international. International stocks are finally trending in the right direction as economic growth and attractive valuations are leading to higher stock prices.

"Finally the recovery has really picked up in the rest of the world. It’s moving along faster than the US because it’s trailed. The US is further along because the central bank here really was aggressive in quantitative easing first”

-Jack Ablin, CIO, BMO Private Bank

The 10-year Treasury finished the second quarter with a yield of 2.29% after falling as low as 2.12% in June, a low for the year. Similar to the first quarter, short term rates rose in a reaction to interest rate hikes from the Federal Reserve and long term rates fell due to low levels of inflation, resulting in a continued flattening of the yield curve.

Domestic markets at a glance}

· The S&P 500 (The 500 largest companies included in the market) finished the second quarter up 8.2%.

· TheDow Jones (The 30 largest publicly traded U.S. companies) finished the second quarter up 8.0%.

· The NYSE Composite Index (all stocks trading on the New York Stock Exchange) finished the second quarter up 6.4%.

Domestic equity markets continued their climb upward in the second quarter, making it the seventh consecutive quarter with positive returns for major market indices. First quarter earnings reports delivered an approximate 14% year-over-year growth rate, it’s highest since 2011. Outsized valuations were somewhat vindicated as nearly 75% of companies exceeded earnings expectations, providing hope that earnings will justify valuations, and the market may continue its ascent.

The technology sector continued to lead the way thanks to gains from the FAAMG stocks (Facebook, Apple, Amazon, Microsoft, and Google). The technology sector, as a whole, finished the quarter up 17.2%. Healthcare, not far behind, is up 16.1% at quarter end. Healthcare service providers and medical device makers enjoyed a solid quarter as potential beneficial healthcare reform seems to be on the horizon with drug price reform put on the backburner.

“The job market remains in good shape eight years into the economic expansion.”

-Gus Faucher, Chief Economist, PNC Financial Services

Job creation was strong for the quarter; 207,000 in April, 152,000 in May, and 222,000 in June for a total of 581,000 for the quarter. Despite favorable hiring reports, the unemployment rate ticked up from 4.3% to 4.4% due to more individuals entering the labor force. Wage growth remains below target as higher availability of jobs hasn’t yet translated into higher wages.

Recent political events continued to threaten the agenda of President Trump but it hasn’t resulted in significantly elevated levels of volatility. Over five months into his presidency, President Trump has yet to successfully push through his first piece of legislation. The repeal and replacement of the Affordable Care Act seems destined to die in the Senate unless numerous revision are made. All eyes are on Washington as the ‘Trump trade’ may have run its course without significant legislation including corporate tax cuts, deregulation and infrastructure spending, in addition to the Affordable Care Act.

Bond markets at a glance}

· The Barclay’s Aggregate Bond Index finished the second quarter up 2.27%.

· TheBarclay’s Corporate High Yield Index is now up 4.87% for the year.

· TheBarclay’s US Intermediate Credit Index was up 2.52% after the second quarter.

In a highly anticipated move, the Federal Reserve did indeed initiate a 0.25% interest rate hike after their June 13-14 meeting in an effort to return to normal monetary policy. The Federal Funds target rate is now 1.00%-1.25%. The move pressured short-term interest rates higher while softer than anticipated inflation data pressured long-term rates lower, resulting in the continuing flattening of the yield curve. 2017 began with an approximate 125 basis point spread between the 10-year and 30-year Treasury. More recently, the spread has dropped as low as 80 basis points. A flattening of the yield curve is generally an indication that investors are concerned about macroeconomic conditions, which seems to be at odds with equity markets.

"The outcome that the current FOMC is so focused on avoiding, high inflation of the 1970s, may actually be leading us to repeat some of the same mistakes the FOMC made in the 1970s: a faith-based belief in the Phillips curve and an underappreciation of the role of expectations. In the 1970s, that faith led the Fed to keep rates too low, leading to very high inflation. Today, that same faith may be leading the Committee to repeatedly (and erroneously) forecast increasing inflation, resulting in us raising rates too quickly and continuing to undershoot our inflation target.

-Neel Kashkari, President, Minneapolis Fed

Neel Kashkari, President of the Minneapolis Fed, was the lone dissenter on the most recent rate hike. The other 8 members who voted for a rate hike did so, in part, due to a concern about rising inflation. Kashkari felt inflation is much less of a problem as it’s continuously been well below the Fed’s 2% target for the last several years. In addition, although the unemployment rate has achieved pre financial crisis levels, the percentage of 25-54 year olds in the labor force has not.

The Bloomberg Barclays Treasury 5-7 Year Index rose 1.1% for the quarter. The Bloomberg Barclays U.S. Corporate 5-10 Year Index advanced 2.2%. High yield bonds also continued their quarterly advance, gaining 2.2% and is now up over 12% over the last year. Municipal bonds were also positive for the quarter with the Bloomberg Barclays Municipal Bond Index rising 2%.

Foreign markets at a glance}

· The MSCI EAFE Index was up 11.83% after the second quarter.

· The Dow Jones Global Ex US was up 13.84% at quarter end.

· The Nikkei JASDAQ Average (Japan) was up 17.95% through quarter end.

Global markets outperformed domestic markets in the second quarter of 2017 on the heels of strong earnings growth, positive economic data, and lessened political uncertainty in Europe. The MSCI Emerging Markets index rose 6.3% and the MSCI World Ex US advanced 5.6%. This is the second consecutive quarter that foreign markets have outperformed domestic.

"There’s no sign of the impressive performance ending any time soon. Optimism about the year ahead has risen to the highest for at least five years backlogs of orders are building up at the fastest rate for over seven years and factories are reporting near-record hiring as they struggle to deal with the upturn in demand.”

-Chris Williamson, Chief Business Economist, HIS Markits

The slow and steady recovery continued in Europe in the second quarter as numerous economic indicators showed improvement. Investors appear to be gaining confidence that economic growth can be sustainable despite its recent inconsistency. This confidence seems to be shared by the European Central Bank as it signals its intention to veer from its extraordinarily easy monetary policy.

Emerging markets registered strong gains in the second quarter thanks to an improvement in global growth and the weakness in the U.S. dollar. China received solid macroeconomic data despite its intention to slowly withdraw liquidity. Greece reached an agreement with creditors to release a €8.5 billion loan tranche.

In Closing}

As we move into the third quarter of 2017, there are a variety of events that can have an impact on both domestic and foreign markets.

The Federal Open Market Committee meets again in July following last month’s interest rate hike. If economic growth or inflation show any signs of slowing, we could see the Fed wait until the September meeting to determine if another rate hike is appropriate.

The Congressional Budget Office has projected that the Treasury can sustain its operations without increasing the debt ceiling though the middle of October. A vote whether to increase the debt ceiling could become combative and have negative market implications as it has in years past.

The United Kingdom and European Union’s Brexit negotiating teams will meet later this month in Brussels for the first full week of negotiations. A full year after the referendum vote to leave the European Union, Theresa May, Prime Minister of the United Kingdom, still faces the challenge of coming to a consensus of what “type” of Brexit Britain wants.

Improving economic data coming out of Europe and Japan will put more pressure on their respective central banks to begin constructing a plan to unwind their accommodative monetary policies. Both countries, however, are still failing to meet their target inflation numbers.

MGO Investment Advisors will continue to monitor the markets closely, seeking opportunities that enhance investor portfolios over the long term.

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